The Economist: The DeFi market battle is intensifying

For believers, open public blockchains offer a second chance to build a digital economy. The fact that applications built on these blockchains collaborate and the information they store is visible to everyone recalls the idealism of the early architects of the internet, before most users embraced it The "walled garden" provided by the tech giants. Over the past year, as applications built on various blockchains have flourished in scale and functionality, a new "decentralized" digital economy has become possible.

Perhaps the most important part of this digital economy are decentralized finance (DeFi) applications that enable users to trade assets, obtain loans, and store deposits. Now, the battle for market share in this area is intensifying. On top of that, Ethereum, the leading DeFi platform, appears to be losing its near-monopoly status. The race shows how DeFi has been affected by the standards wars that have erupted in other emerging technologies—think Sony’s Betamax and VHS tape battles in the 1970s—and also illustrates how DeFi technology can be lightning-fast. progress at a similar rate.

The idea behind DeFi is that blockchains — databases that are distributed across many computers and kept secure by cryptography — can help replace centralized institutions like multinational banks and technology platforms. The value of assets stored in this nascent financial system (DeFi) has climbed from less than $1 billion in early 2020 to over $200 billion today, see chart below.

DeFi Above: Growth in assets stored in DeFi applications since 2020. Data source: DeFi Llama

Until recently, the Ethereum blockchain was the undisputed leader of all this DeFi activity. Ethereum was created in 2015 as a more general version of Bitcoin. Bitcoin’s database stores transaction information for related cryptocurrencies (i.e. BTC), providing proof of who owns what at any time. In contrast, Ethereum stores more information, such as lines of computer code. Ethereum applications programmed with code are guaranteed to behave as written, eliminating the need for intermediaries. But just as Ethereum continues to improve upon Bitcoin, it is now being seized by newer and better technology. Jeremy Allaire, the boss of Circle, the company that issued the popular U.S. dollar stablecoin USDC, said the competition is like a competition between computer operating systems.

Current blockchain technology is clumsy and slow. Both Bitcoin and Ethereum use a mechanism called "PoW" (Proof of Work), where computers compete to solve mathematical problems to verify transactions in exchange for rewards. This slows down the network and limits capacity. Bitcoin can only process 7 transactions per second; Ethereum can only process 15. When the network is busy, transactions are either slow or expensive (and sometimes both). When there is a high demand for completed transactions on the Ethereum network, transaction fees paid to the computers (nodes) that validate those transactions rise, as does settlement time. You might have spent $70 to convert $500 into ETH, and then waited several minutes from one crypto wallet to another.

Developers have long tried to increase the capacity of Ethereum. In fact, one of the directions is to change the consensus mechanism of the blockchain. Later this year, developers plan to transform Ethereum into a more easily scalable mechanism called "PoS" (Proof of Stake). Another idea is to split the blockchain (through a process called "sharding"). These shards will share this load, increasing capacity. Additionally, some developers are working on ways to bundle transactions (like Rollups) to reduce the number of transactions that must be verified directly (on the L1 mainnet).

The problem is, every improvement comes with a cost. Proponents of DeFi tout the advantages of being able to conduct transactions securely and without the involvement of a centralized intermediary. But the scalability gains must be weighed against the loss of security or decentralization. Centralizing transactions before they reach the blockchain, which is usually done by a centralized entity. It may be easier for a hacker to attack one shard of the blockchain than the entire blockchain. As a result, Ethereum developers have been slowly making changes to it.

This slowness has worked against the network in another way -- driving the rise of competitors. In early 2021, almost all assets locked in DeFi applications are on the Ethereum network. But a recent JPMorgan Chase research report estimated that by the end of 2021, the share of assets locked in DeFi applications on Ethereum had fallen to 70%. A growing number of other networks, such as Avalanche, Binance Smart Chain, Terra, and Solana, now use PoS to run blockchains that do the same basic job as Ethereum but are faster and less expensive . For example, two blockchain networks, Avalanche and Solana, process thousands of transactions per second.

What happened to the USD stablecoin USDC illustrates these shifts. USDC was launched on the Ethereum network three years ago, but has since been launched on a number of rival networks, including Algorand, Hedera, and Solana. Jeremy Allaire, boss of Circle, the issuing company behind USDC, said that transactions on Ethereum are limited by cost and speed, while transactions on Solana can handle “Visa-scale transaction volumes,” with “settlement times of about 400 milliseconds and transaction costs of about one-twentieth penny". Other DeFi applications, such as SushiSwap, an exchange founded on Ethereum, have also been launched on several other blockchain networks.

With some changes in ethereum’s plans likely to take at least a year, if not longer, “the risk is… that the ethereum network will lose further market share,” JPMorgan’s Nikolaos Panigirtzoglou wrote. For Jeremy Allaire, the current landscape is full of competition. “Just like in networking, there is competition between Windows, iOS and Android, and there is competition between blockchain platforms.” He believes the ultimate winner will be the one that attracts the best developers to build apps and thus gain network effects The internet.

But the operating system metaphor may only go so far, in part because of the nature of open public blockchains. Anyone can access the data they produce and view their operational code, making it possible to build "bridges" or applications across multiple blockchain networks, as well as applications that aggregate information between different blockchains become possible. Some applications, such as the decentralized exchange aggregator 1inch, are already "scanning" exchanges on various blockchains to find the best execution price for cryptocurrency transactions; while "multi-chain" districts such as Polkadot and Cosmos Blockchain, which operates like a "bridge" between different networks, makes it possible to operate across networks.

As long as DeFi has the potential to be successful, the race to become the DeFi network of choice will naturally intensify. But the idea of "winner takes all and gains total control over the digital economy and how it develops" may one day be as outdated as videotape.

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